Lecture 4

Scope of Managerial Economics

 Scope of Managerial Economics

• Managerial economics is widely applied in

organizations to deal with different business
issues.
• Both the micro and macroeconomics equally
impact the business and its functioning.
• Following points illustrate its scope:
 Operational Issues
• An operational definition is the articulation of
operationalization (or statement of procedures)
• used in defining the terms of a process (or set of
validation tests and the expected outcomes)
• needed to determine the existence of an item or
phenomenon (a variable, term, or object) and its
properties such as duration
 Micro-Economics applied to Operational Issues

•To resolve the organization's internal issues arising in business

operations, the various theories or principles of microeconomics
applied are as follows:
•Theory of Demand: The demand theory emphasizes on the
consumer’s behavior towards a product or service.
•It takes into consideration the needs, wants, preferences and
requirement of the consumers to enhance the production process.
•Theory of Production and Production Decisions: This theory is
majorly concerned with the volume of production, process, capital
and labour required, cost involved, etc.
•It aims at maximizing the output to meet the customer’s demand.
 Micro-Economics applied to Operational Issues cont.

• Pricing Theory and Analysis of Market Structure: It focuses on the

price determination of a product keeping in mind the competitors,
market conditions, cost of production, maximizing sales volume, etc.
• Profit Analysis and Management: The organizations work for a profit.
• Therefore they always aim at profit maximization.
• It depends upon the market demand, cost of input, competition level,
etc.
• Theory of Capital and Investment Decisions: Capital is the most
critical factor of business (production).
• This theory prevails the proper allocation of the organisation’s capital
and making investments in profitable projects or venture to improve
organizational efficiency.
 Business Environment

• Business Environment is sum or collection of all

internal and external factors such as employees,
customers needs and expectations, supply and
demand, management, clients, suppliers, owners,
activities by government, innovation in technology,
social trends, market trends, economic changes, etc.
• These factors affect the function of the company and
how a company works directly or indirectly.
• Sum of these factors influences the companies or
business organisations environment and situation.
Macro-Economics applied to Business Environment

 Any organization is much affected by the environment it operates in.

• Therefore the business environment can be classified as follows:
• Economic Environment: The economic conditions of a country, GDP,
economic policies, etc. indirectly impacts on the business and its operations.
• Social Environment: The society in which the organization functions also
affects it like employment conditions, trade unions, consumer cooperatives,
etc.
• Political Environment: The political structure of a country, whether
authoritarian or democratic; political stability; and attitude towards the
private sector, influence organizational growth and development.
 Managerial economics provides an essential tool for determining the
business goals and targets, the actual position of the organization, and what
the management should do fill the gap between the two.
 Economic Environment
• The term economic environment refers to all
the external economic factors
• that influence buying habits of consumers-
theory of the Consumer, and businesses and
therefore affect the performance of a company.
• These factors are often beyond a company’s
control, and may be either large-scale (macro)
or small-scale (micro).
 Macro factors
 These include:
• Employment/unemployment
• Income
• Inflation
• Interest rates
• Tax rates
• Currency exchange rate
• Saving rates
• Consumer confidence levels
• Recessions
 Micro factors
 These include:
• The size of the available market
• Demand for the company’s products or services
• Competition
• Availability and quality of suppliers
• The reliability of the company’s distribution chain (i.e., how it
gets products to customers)
• While companies often can’t control their economic
environment, they can evaluate economic conditions before
choosing to enter a particular market or industry or pursue
other strategies
 Social Environment
• social environment  comprises of society and all surroundings influenced
in some way by humans.
• It includes all relationships, institutions, culture, and physical structures.
• The social environment, social context, sociocultural
context or milieu refers to the immediate physical and social setting in
which people live or in which something happens or develops.
• It includes the culture that the individual was educated or lives in, and the
people and institutions with whom they interact. 
• The interaction may be in person or through communication media, even
anonymous or one-way, and may not imply equality of social status.
• The social environment is a broader concept than that of social class or 
social circle.
 Political Environment
• Government actions which affects the
operations of a company or business. These
actions may be on local, regional, national or
international level.
 Economic Environment-Theory of Demand
Demand and Pricing

• Decisions related to demand and pricing are

usually called marketing decisions
• Theory of the Consumer
• microeconomic theory endeavours to explain
how consumers behave
• A consumer is someone who makes
consumption decisions for herself or for her
household unit
Demand and Pricing - Consumption Cont

• From demand driven point of view, consumption is

largely facilitated by purchases for goods and services.
• Some of these goods and services are essential to a
consumer’s livelihood, but others are discretionary,
perhaps even a luxury.
• Consumers are limited in how much they can consume
by their wealth.
• A consumer’s wealth will change over time due to
income and expenditures
 Demand and Pricing Cont
• Consumers exhibits trade off effects
• might be able to borrow against future income so as to increase her
capacity to purchase now in exchange for diminished wealth and
consumption later.
• may retain some of his/her current wealth as savings toward
increased future consumption.
• Consumption decisions may be planned into the future, taking account
of the expected changes in wealth over time {Expected income effect}.
• The theory of the consumer posits that a consumer plans her
purchases, the timing of those purchases, and borrowing and saving
so as maximize the satisfaction she and her household unit will
experience from consumption of goods and services.
 Demand and Pricing Cont.

• Consumer Preferences
• In theory, consumers are able to compare any two patterns of consumption,
borrowing, and saving and deem that either one is preferred to the second
or they are indifferent between the two patterns, this is called as ranking of
choices.
• Price Signalling Effect
• Based on the ability to do these comparisons, consumers look at the prices
charged for various services now, and what they expect prices to be for
goods and services in the future, and select the pattern of consumption,
borrowing, and saving that generates the greatest satisfaction over their
lifetime within the constraint of their wealth and expected future income.
• Although the consumers may anticipate changes in prices over time, they
may find that their guesses about future prices are incorrect.
 Ranking of Choices

• Consumer Preferences
• In theory, consumers are able to compare any two patterns of consumption,
borrowing, and saving and deem that either one is preferred to the second
or they are indifferent between the two patterns, this is called as ranking of
choices.
• Price Signalling Effect
• Based on the ability to do these comparisons, consumers look at the prices
charged for various services now, and what they expect prices to be for
goods and services in the future, and select the pattern of consumption,
borrowing, and saving that generates the greatest satisfaction over their
lifetime within the constraint of their wealth and expected future income.
• Although the consumers may anticipate changes in prices over time, they
may find that their guesses about future prices are incorrect.
Substitution Effect and the Income Effect

• When anticipated price variation differs from

the reality, the theory states that they will
adjust their consumption, borrowing, and
saving to restore the optimality under the
newly revealed prices.
• In fact, the theory identifies two effects of
price changes: the substitution effect and the
income effect.
 Marginal Analysis
• The substitution effect is based on an argument
employing marginal reasoning like the marginal
analysis discussed earlier under Key Measures and
Relationships
• Economists usually use the term utility as a
hypothetical quantitative value for satisfaction that a
consumer receives from a pattern of consumption.
• If a consumer were to receive one more unit of some
good or service, the resulting increase in their utility is
called the marginal utility of the good
 Marginal Utility
• As a consequence of maximizing their overall
satisfaction from consumption, or equivalently
maximizing their utility, it will be the case that if you
take the marginal utility of one good or service and
divide it by its price, you should get the same ratio
for any other good or service when added.
• If they were not roughly equal, the consumer would
be able to swap consumption of one good or service
for another, keep within their wealth constraint, and
have higher utility
 Substitution Effect

• The substitution effect is the consumer’s

response to a changing price to restore
balance in the ratios of marginal utility to
price.
• As the result of price changes and substitution,
the consumer’s overall utility may increase or
decrease. Consequently, the consumer may
experience the equivalent of an increase or
decrease
 Substitution and Income Effect
• As the result of price changes and substitution, the
consumer’s overall utility may increase or decrease.
• Consequently, the consumer may experience the
equivalent of an increase or decrease in wealth, in
the sense that it would have required a different
level of wealth to just barely afford the new
consumption pattern under the previous set of
prices.
• This equivalent change in purchasing power is called
the income effect
 Precise Techniques
• Economists have precise techniques for separating
the response to a price change into a substitution
effect and an income effect.
• Price changes will affect the mix of goods and
services that is best and change the consumer’s
overall level of satisfaction, through Price Differential
Effect.
• In most cases, the primary response to a price
change is a substitution effect, with a relatively
modest income effect.